Full Costing

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Full Costing (Absorption Costing)

Full costing, also called absorption costing, is an accounting method that allocates all product-related costs—direct, variable overhead, and fixed overhead—to units of production. It produces a “full” per‑unit cost that is carried in inventory until the related goods are sold, at which point those costs flow to cost of goods sold (COGS).

How it works

  • All manufacturing costs are included in product cost:
  • Direct costs: raw materials, direct labor, and other costs directly traceable to production.
  • Variable overhead: indirect costs that change with production volume (e.g., power, piece‑rate labor).
  • Fixed overhead: indirect costs that don’t vary with short‑term production (e.g., factory rent, salaried supervisors).
  • Costs are capitalized in inventory accounts while units remain unsold.
  • When products are sold, the capitalized costs are recognized as COGS on the income statement.

Full Costing vs. Variable (Direct) Costing

The primary difference is how fixed manufacturing overhead is treated:
– Full costing: fixed manufacturing overhead is allocated to units and included in inventory; it becomes an expense when products are sold.
– Variable costing: fixed manufacturing overhead is expensed in the period incurred and not included in inventory; only variable production costs are assigned to units.

Implications:
– External reporting and tax rules (GAAP/IFRS) require absorption (full) costing.
– Variable costing is often preferred for internal management decision‑making because it isolates the costs that change with production volume.

Simple example

Assume fixed manufacturing overhead = $1,000; variable cost per unit = $5; produce 200 units; sell 150 units; selling price $20/unit.

Absorption shows higher profit by $250, equal to the fixed overhead deferred in inventory for the 50 unsold units (50 × $5).

Advantages

  • Complies with GAAP/IFRS and tax reporting requirements.
  • Provides a complete per‑unit cost for pricing and long‑term decisions.
  • Smooths profit reporting when production and sales volumes differ (useful for seasonal producers).

Disadvantages

  • Can obscure product‑level profitability by allocating shared fixed costs across products.
  • Makes short‑term cost‑volume‑profit (CVP) analysis and operational efficiency improvements harder, since fixed costs are hidden in unit costs.
  • May inflate reported profit when production exceeds sales, because some fixed costs are deferred in inventory.

When to use

  • Required for external financial statements and tax filings.
  • Useful for setting long‑term prices and assessing total investment in inventory.
  • For internal decision‑making, costing methods should be chosen based on the decision context: use variable costing for short‑term, volume‑sensitive analyses and full costing for long‑term pricing and compliance.

Practical considerations

  • Just‑in‑time (JIT) and low‑inventory systems reduce the impact of absorbed fixed costs, diminishing the practical differences between methods.
  • Many companies use absorption costing for external reporting and variable costing for managerial reports and operational decisions.